A review and interpretation of current happenings in the world of economics and finance

Tuesday, July 28, 2009

Does Economics Work?

Does economics work?

A lot of people seem to be questioning the validity of economics these days.

My answer to this question is an emphatic yes! Economics does work!

It is only when we forget the basic principles of economics that we get into trouble. In recent years we have forgotten some of those principles and this has resulted in the economic chaos that we find ourselves in today. I would like to concentrate on just three of these principles for I believe that in forgetting these we have created a lot of our own unhappiness.

The first principle relates to what can be called the “value proposition”. Basically in economics it is argued that value or wealth is created when economic units produce goods or services that provide people with utility. That is, unless the economic unit that is producing something adds value to the resources used in the production of those goods and services, people will not purchase them and wealth will not be created.

Innovation is very important to this process because innovation creates new value in developing something new that people come to want. Where there is not a lot of competition in a particular market because the good or service being produced is new or where firms can achieve what is called competitive advantage, the rate of return on invested capital can exceed the opportunity cost of the capital used to produce those goods and services. In other words, under circumstances like these, firms can find projects or investments that have a positive net present value. Wealth is created in such situations.

But, economic units respond to incentives and when other economic units discover an area where the rates of return on invested capital exceed the opportunity cost of raising capital, they will be attracted to enter that market. And, unless there are barriers to entry in entering that market or some other economic factor or government license, patent, or regulation preventing that entry, competition will increase and this will drive down the excess of return on capital over the cost of capital. In the process, more and more goods are produced at lower prices.

Thus, the creation of wealth in society has to do with the fact that economic units must produce goods and services that are of value to others within the society. This is the value proposition.

The second principle is the “no arbitrage” principle. This principle has to do with trading goods or trading financial instruments. Trading occurs when the prices of an asset or of similar assets differ in different markets. The different markets might relate to different geographic areas, to different time zones, to different countries, to any situation in which there might occur a difference in the price of a good. These differences occur because of transaction costs, incomplete information, lack of computing power, and so on.

The “no arbitrage” principle essentially argues that trading opportunities such as these will attract investors seeking to take advantage of the price differentials and through trading to profit from these differentials the differences will go to zero or will be reduced to a spread related to transaction costs. That is, the incentive to profit through arbitrage trading will be eliminated or reduced over time. In other words, the expected value of arbitrage trading is zero. It is a zero-sum game.

There are two things that must be remembered with respect to trading. First, as more and more people discover the price discrepancies in different markets the potential gains from such trading are reduced. As these potential gains decline, traders may attempt to maintain rates of return on such trades by working with riskier assets, by mismatching the maturities of the arbitrage transactions with the funds used to achieve the position, or by increasing the amount of leverage they use. History is clear that as the potential returns to trading decline, traders take on more and more risk in an effort to enhance their performance. Research indicates that the big winners in trading are those that discover the discrepancies before anyone else does.

Second, the whole basis for this kind of arbitrage transaction is that the prices of the assets in different markets move in the opposite direction. This is obvious in a common assumption of arbitrage trading called “reversion to the mean.” In this case, the price of the asset in one market is above the mean price and the price of the asset in another market is below the mean price. The arbitrager is betting that over time the price of the asset above the mean will fall and the price of the asset below the mean will rise and money will be made.

The problem comes when these two prices move in the same direction! Unless the arbitrager is able to continue to finance his/her position over a long period of time he/she will have to take a loss, possibly a substantial loss. Keynes argued that arbitragers will find that they cannot maintain their financing over a sufficiently long period to keep up such an arbitrage position. This is, of course, what happened to Long Term Capital Management.

The third principle is related to the creation of money and credit. The basic idea here is that the creation of money and credit cannot exceed the creation of the real goods and services being produced by a society. In other words, when the growth of money and credit in a society or, in a particular sector of the economy, exceeds the growth rate of the economy or the growth at which goods and services can be produced in a particular sector, prices can become inflated. In terms of the general economy, inflation can occur. In terms of particular sectors of the economy, like housing or companies, asset bubbles can occur. In either case, economic dislocations result that, if the inflation or asset bubble continues, a correction will eventually have to take place. This correction results in a slowdown in economic growth, either in the economy as a whole or in a particular sector, as economic units get their balances sheets back in order with the use of much less debt. That is, credit inflations are followed by debt deflations.

One further complicating factor is that during credit inflations, like those described in the previous paragraph, the economy usually shifts from the emphasis on the value proposition to emphasis on trading. This only exacerbates the dislocations that occur in the economy and makes any correction just that much broader and deeper. Trading, in these situations, is not the basis of a robust economy; creating value is. A correction restores the balance between value creation and trading.

Yes economics works! These three principles are still in place. And, my guess is that they will remain in place for many more years. We only forget them to our own harm!

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About Me

Professional history:
Banking--President and CEO of two publically traded financial institutions; Executive Vice President and CFO of another.
Academic--Professor at Penn State University and at the Finance Department, Wharton School, University of Pennsylvania.
Government--Special Assistant to Secretary George Romney at Department of Housing and Urban Development; Senior Economist in Federal Reserve System.
Entrepreneurial--work in venture capital and other private equity; work with young entrepreneurs in urban environment.